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Thursday, September 25, 2008

Jugdment Day Approaches

It appears as if all the cards have now been put on the table. The United States government took a minor pause in their never ending streak of bailouts two weekends ago with their decision not to bail out Lehman Brothers. Lehman Brothers is considered a small fish in the big sea of investment banks, and if there was one to let fail it was going to have to be them.

What happened when they allowed that bankruptcy? Four days later, on Thursday, September 18, we were about six or seven minutes away from the equivalent of financial armageddon. Henry Paulson spent the night before and all that morning watching what is called the money market accounts of the world freeze up. Billions of dollars began pouring out of the accounts as people started to panic. Just before lunch time, according to many traders, we were about five trades from the Dow plummeting down to the 7-8,000 level.

Paulson immediately announced to the markets the he was injecting $105 billion into the money markets, and four hours later he released word of "The Bailout." After letting Lehman fail, the government has decided they were not very happy with the market response, and they have now decided to bail out EVERYONE all at once. Details of the bailout followed soon there after, which include immediate access to $700 Billion to purchase assets from balance sheets.

There are three steps to how this nightmare unfolds before our eyes:

The government will first begin to pour through bank's balance sheets (both domestic and foreign) and purchase all the toxic mortgages that no one will even bid for right now. Even though these assets cannot find ANY price in the open market, they feel they can come in and over pay for them and ultimately make a large profit for the tax payers. They will start this process right away buying everything in sight that may slow down the credit markets. Now, with all this toxic debt sitting on their books, what is the most important factor that will keep these assets from dropping in price?

That's right, the value of American homes, which are the underlying asset for all these debt instruments. Now how could the government figure out a way to keep home prices from falling? If only there was a way they could loosen up lending restrictions again that allowed home prices to get to these bubble values. If only there was a way they could convince banks to make crazy loans again because they could sell them into the secondary market with no repercussions like there were before. In order to do that they'd have to do something completely insane like take over Fannie and Freddie.

Oh wait, that already happened. Which brings us to step two. Over the next few years you'll start to see loan restrictions loosen closer to where they were during the bubble years. All banks will sell these loans to Fannie and Freddie who will be the only buyer left. Their portfolio will grow from about $6 Trillion to about $10 Trillion in the next two years. These loosened lending restrictions will keep home prices at a much higher level than they would be set in the free market and thus not allow all the mortgage backed securities that the government is purchasing to fall to their true price.

We may not even make it to step three, but here's what happens if we do. Even with the government artificially propping up the value of housing and the credit market our country will continue into a severe recession. The next major defaults will come in the form of auto loans and credit card loans that have also been securitized like home loans. With its new powers the government will go back again and again for additional money to "save" the economy. They will begin purchasing these assets, and helping every troubled group that may slow down the economy in any way. The total cost for "The Bailout" will end up approaching $3 Trillion.

The question a few people are asking is, "Where will this money come from?" Well, we are currently $56 Trillion in the hole, and we run about a $500 Billion to $1 Trillion deficit every year now. So it cannot come from our tax payers or from the savings of Americans because they don't have any. The first choice is to try to convince foreign countries to lend it to us. Unfortunately, as every day passes they are starting to see that lending trillions of dollars to Americans that can never pay them back poses a significant risk to their own economies. They feel this every day in dealing with the amount they lent over the past few years for subprime loans, new cars, vacations, and big screens.

The second and last choice is to print the money. This is the option that will be pursued when the foreign investments are finally cut off. We will begin to monetize all this debt and begin moving toward hyperinflation. The dollar will begin its plummet and there will be nothing to stop it. The Fed will have to raise interest rates through the roof to try to save the currency, but this will crush what little economy we have left, and have the effect of beating the dollar down into oblivion.

Foreign investors will then enter our country which will now be destroyed and laying in ruins, and they will begin to purchase our remaining assets at pennies on the dollar with their strong currencies. Real estate, performing companies, and our stocks will on be on a fire sale.

This obviously seems unfair and frightening if you're an American. You get paid in American dollars, save your money in American dollars, and thus will get wiped out with everyone else when this happens. But here is the interesting part; You don't have to save your money in American dollars. Right now, I say that because at some point the government may make it illegal, you can save your money in Euros, Yen, Swiss francs, Canadian dollars, and even something called gold.

When the boats come from overseas and everyone goes shopping on American assets, which have been annihilated, you can be one of those shoppers.

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and but she will never sit down on a cold one either."

- Mark Twain

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait."

- Charlie Munger

"Live as if you were to die tomorrow. Learn as if you were to live forever."

- Gandhi

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel."

- Jim Rogers

"Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

- James Grant

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

- Ben Bernanke, March 2007

"Everything that needs to be said has already been said. But since no one was listening, everything must be said again."

- Andre Gide

"When people are getting richer and richer but they're not actually producing anything, it can't end well."

- Louis CK

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could."

- Rudiger Dornbusch

"I don't write about what I know. I write to find out what I know."

- Patricia Hampl

"Chains of habit are too light to be felt until they are too heavy to be broken."

- Warren Buffett

"Everyone has a plan until they get punched in the mouth."

- Mike Tyson

"Interest on the debt grows without rain."

- Yiddish Proverb

"You can have comfort, or you can have value. You cannot have both."

- Jim Grant

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

-Ludwig von Mises

"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

- Howard Marks

"Whenever you find yourself on the side of the majority, it is time to pause and reflect."

-Mark Twain

"None are more hopelessly enslaved than those that falsely believe they are free."

-Goethe

"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

-John Coumarianos

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

-Jean Monnet

Requiring a central bank to print money to increase government's purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.

- Alan Greenspan

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"Do you want to sell sugared water for the rest of your life? Or do you want to come with me and change the world?"

-Steve Jobs

"I'd be a bum on the street with a tin cup if the markets were always efficient."

-Warren Buffett

"The market can stay irrational longer than the investor can stay solvent."

- Keynes

"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

-Ayn Rand, 1974

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function."

- F. Scott Fitzgerald

"All our life, so far as it has definite form, is but a mass of habits - practical, emotional, and intellectual - systemically organized for our weal or woe, and bearing us irresistibly toward our destiny, whatever the latter may be."

-William James

"Men it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

- Stephen Hawkings

"Give me control of a nations money supply, and I care not who makes it's laws."

- Amschel Rothchild

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

- Sigmund Freud

Many of life's failures are people who did not realize how close they were to success when they gave up.